Did you ever wonder why some things were cheaper when older family members were growing up and why those things are so expensive now? It has to do with inflation. But how can you tell if prices are getting higher or lower? And how does the government know when to step in to stop prices from getting out of control? The simple answer is price indices. When governments are aware of the situation via price indices, then they can take the necessary steps to stop the negative effects of price changes. To find out how to calculate price indices, the types, and more, keep reading.
Price Indices definition
Much like economic experts prefer a specific number to describe the main level of output, they prefer a single specific number to indicate the general level of prices, or the aggregate price level.
Aggregate price level is a gauge of the economy's total price level.
Real wages are earnings taking inflation into account, or earnings expressed in terms of the quantity of products or services that may be purchased.
But the economy produces and consumes so many and such a wide range of commodities and services. How can we possibly sum up the pricing of all of these items and services into a single figure? The answer is a pricing index.
A pricing index calculates the cost of buying a specific market basket in a particular year.
Assume a conflict breaks out in a country on which your society relies for crucial food goods. As a result, the price of flour goes up from $8 to $10 per bag, the price of oil goes up from $2 to $5 each bottle, and the price of corn goes up from $3 to $5 every pack. How much has the cost of this imported vital food risen?
One approach to finding out is to mention three numbers: the price changes for flour, oil, and corn. However, this would take a long time to complete. It would be much easier if we had some type of general metric of the average price change rather than worrying about three separate numbers.
Economists monitor differences in the cost of an average customer's consumption bundle—the average basket of products and services purchased before the price fluctuates—to estimate average price changes for products and services. A market basket is a theoretical consumption bundle that is used to track changes in the overall price level.
A consumption bundle is the average basket of products and services purchased before the price fluctuates.
A market basket is a theoretical consumption bundle that is used to track changes in the overall price level.
Real vs nominal values
Labor becomes less expensive when the real salary that corporations pay their employees declines. However, because the quantity of product generated per unit of labor remains constant, corporations opt to recruit additional workers in order to raise profits. When businesses recruit additional workers, output rises. As a result, when the price level increases, output increases.
Essentially, the reality is that even in the case that nominal wages go up during inflation, that doesn't mean that real wages will also go up. There is an approximate formula used for figuring out the real rate:
Nominal rates don't take inflation rates into account, but real rates do.
For this reason, real rates should be used instead of nominal rates to figure out a person's purchasing power.
If the nominal wages rise by 10% but the inflation rate is at 12%, then the rate of change of the real wages is:
Real wages rate = 10% - 12% = -2%
Which means that the real wages, which represent the purchasing power, actually fell!
Price index formula
The price index formula is:
\(Price\ index\ in\ a\ given\ year=\frac{\hbox{Cost of market basket in a given year}}{\hbox{Cost of market basket in base year}} \times 100 \)
Price indices calculation and example
Economists all have a similar strategy for tracking changes in the general price level: they examine changes in the cost of purchasing a specific market basket. Using a market basket and a base year, we can calculate a price index (a measure of the total price level). It is always used in conjunction with the year for which the aggregate price level is being assessed along with the base year.
Let's try an example out:
Suppose our basket consists of only three things: flour, oil, and salt. Using the following prices and amounts in 2020 and 2021, calculate the price index for 2021.
| Item | Quantity | 2020 Price | 2021 Price |
| Flour | 10 | $5 | $8 |
| Oil | 10 | $2 | $4 |
| Salt | 10 | $2 | $3 |
Table 1. Sample of Goods, StudySmarter
Step 1:
Calculate the market basket values for both 2020 and 2021. Quantities will be indicated in bold.
2020 market basket value = (10 x 5) + (10 x 2) + (10 x 2)
= (50) + (20) +(20)
= 90
2021 market basket value = (10 x 8) + (10 x 4) + (10 x 3)
= (80) + (40) + (30)
= 150
It's worth noting that the same numbers for quantities were used in both computations. The quantities of goods would certainly fluctuate from year to year, but we want to keep these amounts constant so that we can examine the influence of price fluctuations.
Step 2:
Determine the base year and the year of interest.
The instructions were to find the price index for the year 2021 so that is our year of interest, and 2020 is our base year.
Step 3:
Input the numbers into the price index formula and solve.
The price index for 2021 is 167!
This means that the average price increase was 67% in 2021 compared to the base year - 2020.
Types of Price Indices
Inflation is determined by forming inflation indices and these indices essentially are a reflection of the price level at a certain point in time. The index does not contain all prices, but rather a specific basket of products and services. The specific basket used in the index represents the products that are significant to a sector or group. As a result, multiple price indices exist for the costs encountered by various groups. The main ones are as follows: Consumer Price Index (CPI), Producer Price Index (PPI) and Gross Domestic Product (GDP) Deflator. The percent change in a price index, such as the CPI or the GDP deflator, is used to calculate the inflation rate.
Consumer Price Index (CPI)
The consumer price index (commonly known as the CPI) is the most commonly used indicator of the total price level in the United States, and it is meant to represent how the cost of all transactions made by a typical urban household has altered over a set period of time. It is determined by polling market prices for a specific market basket which is designed to depict the expenditure of an average family of four residing in a standard American city.
The CPI is calculated monthly by the U.S. Bureau of Labor Statistics (BLS) and has been calculated since 1913. It's founded on the index average from 1982 to 1984, which was fixed at 100. Using this as a base, a CPI value of 100 indicates that inflation has returned to the rate it was in 1984, and readings of 175 and 225 imply a 75% and 125% increase in inflation, accordingly.
Consumer Price Index (CPI) is a calculation of the cost of an average American family's market basket.
Fig 1. - 2021 CPI. Source: Bureau of Labor Statistics
As shown in Figure 1, this chart depicts the percentage shares of key kinds of spending in the CPI. Vehicles (both used and new) and motor fuel accounted for about half of the CPI market basket on their own. But why is it so important? Simply put, it is a good technique for determining how the economy is doing in terms of inflation and deflation. Individually, it's a great way to get a feel of how costs are evolving. This might help you arrange your budget more effectively. It can also influence how you intend to save your money or start investing.
Unfortunately, the CPI as an inflation metric has some flaws, including substitution bias, which causes it to exaggerate the actual inflation rate.
The substitution bias is a flaw found in the CPI that causes it to exaggerate inflation since it does not factor in when customers opt to substitute one product for another when the price of the product they regularly buy falls.
The consumer price index (CPI) also quantifies the change in salary required by a consumer over time to maintain the same quality of living with a new range of prices as was had under the previous range of prices
Producer Price Index (PPI)
The producer price index (PPI) calculates the cost of a standard basket of goods and services bought by manufacturers. Because product producers are typically quick to increase prices when they detect a shift in public demand for their products, the PPI frequently reacts to rising or falling inflation trends faster than the CPI. As a result, the PPI is frequently seen as a helpful early detection of changes in the rate of inflation.
The PPI differs from the CPI in that it analyzes expenses from the standpoint of the companies that manufacture the items, while the CPI analyzes expenses from the standpoint of consumers.
The producer price index (PPI) evaluates the prices of products and services bought by manufacturers.
Price Indices: Gross Domestic Product (GDP) Deflator
The GDP price deflator, aka the GDP deflator or the implicit price deflator, tracks price changes for all products and services manufactured in a particular economy. Its use allows economists to compare the amounts of actual economic activity from one year to the next. Because it is not dependent on a predefined basket of commodities, the GDP price deflator is a more comprehensive inflation measure than the CPI index.
GDP deflator is a way to track price changes for all products and services manufactured in a particular economy.
It's 100 times the nominal GDP vs real GDP ratio in that year.
I's not technically a price index, but it has the same purpose. It's important to remember the difference between nominal GDP (GDP in today's costs) and real GDP (GDP analyzed using the prices of some base year). The GDP deflator for a particular year is equal to 100 times the nominal GDP to real GDP ratio for that year. Because the Bureau of Economic Analysis—the source of the GDP deflator—analyzes the real GDP using 2005 as the base year, both GDPs for 2005 are identical. As a result, the GDP deflator for 2005 is 100.
Nominal GDP is the total worth of all final products and services generated in an economy throughout a particular year, measured using current prices in the year the output is created.
Real GDP is the total worth of all final products and services produced in an economy throughout a given year, computed using prices from a chosen base year to exclude the impact of price fluctuations.
Importance of Price Indices
Indices aren't just calculated for no reason. They have a significant influence on policymakers' choices and the economy's functioning. For example, they have a direct impact on the earnings of union employees who get cost-of-living modifications based on the consumer price index (CPI).
These indices are also frequently used by employers and employees to assess "fair" compensation raises. Some federal programs, such as social security, determine monthly check modifications based on a form of one of these indices.
The cost of living index data can also be used to assess the working class's living conditions. Salaries in certain regions are modified according to changes in the cost of living price index, so that employees are not strained when prices go up.
Price Indices - Key takeaways
To know the aggregate price level, economists figure out the cost of buying a market basket.
A price index calculates the cost of buying a specific market basket in a particular year.
The yearly percentage change in a price index, commonly the CPI, is used to compute the inflation rate.
The three main types of price indices are the CPI, PPI, and GDP deflator.
To calculate the price index, use the following formula:
Sources:
Bureau of Labor Statistics, Consumer Price Index: 2021, 2022
References
- Fig 1. - 2021 CPI. Source: Bureau of Labor Statistics, Consumer Price Index, https://www.bls.gov/cpi/#:~:text=In%20August%2C%20the%20Consumer%20Price,over%20the%20year%20(NSA).
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